A currency that’s created and controlled by a government. In other words, it exists by government “fiat.” Using the dollar as an example, the U.S. Federal Reserve creates new dollars simply by printing them or injecting electronic “reserves” into the banking system. The supply of dollars thus depends on the decisions of our elected officials and their appointed administrators like the governors of the Fed.

An example of a non-fiat currency would be the gold and silver coins that used to circulate in much of the world. There was only so much of each metal, and the supply only increased when some enterprising miner discovered and dug up more. Governments were unable to create this kind of money out of thin air.

Like the dollar, today’s euro, Japanese yen, and British pound are all fiat currencies. And—here’s the crucial point—every single fiat currency that has existed prior to the current batch was eventually destroyed by its government.

Put simply, governments are fundamentally incapable of maintaining the value of their currencies. Every leader, whether king, president or prime minister, serves at the pleasure of two powerful constituencies: Taxpayers irate about what they currently pay and violently opposed to paying more, and recipients of government help who demand vastly greater levels of spending on everything from defense, to roads, to old age pensions. Alienate either group, and the result can be an abrupt career change.

So our hypothetical leader finds himself with two choices, the most obvious of which is to level with his constituents and explain that there’s no such thing as a free lunch. Taxes are the price of civilization, but government largess can consume only so much of a healthy economy’s output, so no one person or group can have all they want. This looks simple on paper, but in the real world it opens the door to challenge from rivals who have no qualms about promising whatever is necessary to gain power.

Not liking this prospect at all, our leader then turns to his remaining option: Borrow to finance some new spending without raising taxes. Then create enough new currency to cover the resulting deficit. The anti-tax and pro-spending folks each get what they want, and no one notices, for a while at least, the slight decline in the value of each individual piece of currency caused by the rising supply. Human nature being what it is, every government eventually chooses this second course. And the result, almost without exception, is a gradual loss of confidence in the value of each national currency, which we now know as inflation.

But a little inflation, like a little heroin, is seldom the end of the story. Over time, the gap between tax revenue and the demands placed on government tends to grow, and spending, borrowing and currency creation begin to expand at increasing rates. Inflation accelerates, and the populace comes to see the process of “debasement” for what it is: the destruction of their savings. They abandon the currency en mass, spending it or converting it to more stable forms of money as fast as possible. The currency’s value plunges (another way of saying prices soar), wiping out the accumulated savings of a whole generation. Such is the eventual fate of every fiat currency.The Collapse of the Dollar… tells the stories of five of the more spectacular currency crises, but like I said, they all go this way eventually.

For the past few decades, the U.S. has enjoyed an historically unique position. As the most powerful nation in an increasingly globalized world, its currency, the dollar, is in demand as a store of value. That is, investors and central banks in other countries want to hold dollars as alternatives to their own, presumably less stable currencies. This insatiable demand for dollars has handed U.S. consumers and governments a virtually unlimited credit card. And we’ve spent the past two decades maxing it out.

The U.S. is now the world’s biggest debtor nation, and our current economic expansion is only possible because Japan, China, and Europe are willing to finance our trade deficit by, in effect, lending us $800 billion a year. They do this by taking the dollars we pay for their Toyotas, French wine and Chinese electronics, and using them to buy U.S. bonds and other financial assets.

Add it all up, and U.S. debt now comes to about $60 trillion, or $800,000 per family of four, a clearly unsustainable burden. When our trading partners figure out that we’re no longer solvent, they’ll stop lending us money (that is, they’ll use their dollars to buy euros or yen or gold rather than U.S. bonds), and the value of the dollar will plunge. The process has already begun, with decreasing demand for dollars sending the value of the dollar down by more than a third in this decade. But this is just the beginning.

Many things, most of them bad. When foreign investors and central banks stop demanding dollars, U.S. bond prices will fall, which is another way of saying that U.S. interest rates will rise. Mortgage and credit card rates will soar, sending the U.S. economy back into recession. The U.S. government will respond by opening the monetary floodgates, printing as many paper dollars as necessary to keep the economy from collapsing. This surge in supply will send the value of the dollar through the floor. Prices for most things will skyrocket, and people whose life savings are in cash, bank CDs, or dollar-denominated bonds will be wiped out. Many U.S. financial and manufacturing companies will be ruined, along with their stockholders.

THEN the Dollar Disease will go global. The only reason Japan or Europe have been able to generate their current meager rates of growth is the willingness of U.S. consumers to buy their Hondas and BMWs. As the dollar plunges, Asian and European goods, priced in suddenly-appreciating currencies, will become prohibitively expensive for U.S. consumers, who will respond by buying U.S.-made alternatives or nothing at all. Correctly interpreting this change in buying patterns as a threat to their vital export sectors, European and Asian leaders will respond with the only weapon they have left: monetary inflation. They’ll cut interest rates and buy dollars with their currencies, flooding the world with euros and yen the way the U.S. now floods the world with dollars. The result of these “competitive devaluations” will be a death spiral for all major fiat currencies, in which European and Japanese bonds will, eventually, fare as badly as their U.S. cousins.

Until very recently, gold was humanity’s money of choice, for one very good reason: It exists in limited supply, and governments can’t make more of it, so its value tends to be stable. As paper currencies collapse, the world will look for alternatives, one of which is sure to be gold. Massive amounts of global capital will start chasing a very limited supply of gold, sending its value through the roof.

All the conditions that led to its quadrupling so far in this decade are still in place. The U.S. and Europe are still borrowing far more than they can ever hope to pay off, and financing the resulting debt with newly-created paper currency. Oil and other commodities are still in short supply, as demand from China and India soars. And almost without exception, the world’s leaders seem unable to grasp the risks inherent in paper currency that can be created in infinite quantities by government.

Three more reasons:

* Gold’s fundamentals are very positive. The world’s mines produce about 2,500 tonnes of gold a year, while demand for gold is currently running about 4,000 tonnes. And new demand from emerging countries like China and India is soaring.

* The Fear Index is flashing a “buy” signal. This index measures the financial markets’ anxiety about the dollar and the U.S. monetary and banking system, and in the twenty years since GoldMoney’s James Turk invented it, each of its “buy” signals has been followed by a marked, sometimes spectacular, increase in gold’s exchange rate. Chapter 11 of The Collapse of the Dollar… explains the Fear Index in detail, but for now suffice it to say it continues to point to a rising gold price.

* Central bank manipulation is about to backfire. The world’s central banks, led by the U.S. Federal Reserve, have been making up the difference between mine production and gold demand by secretly dumping their gold on the market. They do this by lending their gold for a nominal interest rate to “bullion banks” like JP Morgan Chase and Citigroup, which then sell it and invest the proceeds at higher rates. Because the banks are obligated to return this gold to the central banks, they’re “short” the metal. At some point in the future they have to buy this gold back on the open market. If gold’s price is low, they make money, and if it’s high, they lose. Since it’s currently high and rising, these banks are looking at multi-billion dollar losses. And as these losses mount, the pressure grows to bite the bullet and close out their short positions by buying back their gold. When one bullion bank does this, the others will be forced to follow, producing a classic “short squeeze,” in which all the major bullion banks try to buy at once, sending gold through the roof. Chapter 12 of “The Collapse of the Dollar…” offers an overview of the central banks’ machinations. For a far more detailed treatment, see Sprott Asset Management’s 70-page report, “Not Free, Not Fair: The Long Term Manipulation of the Gold Price,” available at www.sprott.com.

Add it all up — favorable demand trends, a Fear Index buy signal, and the coming central bank short squeeze — and the next few years should be spectacular for gold.

John Rubino is an analyst and investment advisor with Bearing Asset Management, 208-874-8010, which strives to both protect clients from the coming financial crisis and position them for the opportunities that will be available at the bottom.